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Market Price of Variance Risk and Performance of Hedge Funds

This paper implements a model-free approach to measure the market price of the variance risk. In this approach, the value of the variance contract is estimated from prices of traded options. We find that the variance risk is priced, its risk premium is negative and economically very large. In the application to hedge funds, we argue that the variance return is a key determinant in explaining performance of hedge funds. Most hedge funds exhibit negative exposure to the variance return, implying that they routinely "sell" the variance risk. The variance risk factor accounts for a considerable portion of hedge fund historical returns.